As the global recovery limps along (and interest rates creep ever downwards), it seems increasingly clear that the policy of endless easing adopted by central banks here and in Europe and Japan has not had the effects its designers hoped for. Worse still, the world remains governed by the same framework that led it into crisis in 2008. Here, former head of the Bank of England Sir Mervyn King explains his bold new vision for central banking, one that accounts for the radical uncertainty of economic life and will help fight the risk still inherent in the system.
Octavian Report: In your new book The End of Alchemy, you develop an interesting theory: central banking as, rather than a lender of last resort, a pawnbroker for all seasons. Can you explain this concept and how you arrived at it?
Sir Mervyn King: What became very clear during the financial crisis was that central banks were making up a lot of new facilities as they went along. The idea that you can simply rely on the existence of a lender of last resort when a crisis occurs — the idea that you bring out the fire engines from the fire station, spray the fire with liquidity and put it out, and then put the fire engines back in the station and then forget about it until the next crisis — didn’t seem to me to be the right way of thinking about it for two reasons.
First, banks anticipate that you will provide them with support, so they run down their own ability to withstand a crisis and rely entirely on taxpayers and game them into providing support. Secondly, in a crisis you don’t want to have to make up as you go along, because then you’re struggling to deal with a problem which may be a problem for only a few hours and you’re designing long-lasting policy instruments. That’s not a good way to design policy.
When I reflected on the history of the lender of last resort, what became very clear was that the assumption — and it was an assumption — that banks would always have enough liquid collateral in the form of short-term or medium-term claims on government paper to bring to the central bank in the event of a cash crisis for the bank held in the 19th century but did not apply today. In the past it would not take very long for the central bank to examine the quality of this type of collateral and it could immediately provide the cash to the full face value of the collateral which the bank could take back and pay out the depositors or other short-term creditors who were threatening to run from the bank.
In that world, the “lender of last resort” principle is easy to implement and it does prevent a panic. You don’t have to think about it before the crisis. You can genuinely afford to wait until the crisis and then just respond to the demand for cash. The problem is that that is not the world we live in now and it hasn’t been since, really, the 1980’s. What happened was that banks ran down the amount of their holdings of government safe paper to the extent that instead of holding 30 percent of their total assets in that form, they held less than one percent on the eve of the crisis.
This had a number of consequences. The first was that when banks brought collateral to the central bank and said, “We’d like to borrow cash against this collateral,” central banks had never seen this collateral before. They had to design ways of valuing it and deciding the haircuts to impose on the lending. Having to impose a haircut at all is destabilizing because it means you cannot lend to the bank the full face value of the collateral. This makes the other unsecured lenders to the bank more exposed to risk. The more the central bank lends, the more likely it is that other unsecured borrowers will choose to run from the bank. That diminishes the effectiveness of the operation.
The second is that you get gamed into imposing too-small haircuts and taking on a lot of risk for taxpayers, and the principle that Walter Bagehot advanced — which was that when the central bank would lend, it would lend at a higher interest rate than normal in order to prevent banks relying on it as the lender of first resort as opposed to last resort — became impossible to implement in a crisis because to impose a penalty rate merely made the banks’ situation worse.
All of this added up to a very compelling case for not actually leaving such planning until the last moment. It seemed to me that there would be enormous potential advantages in thinking of central banks not as the lender of last resort but as a pawnbroker. That is, being prepared in any circumstances to lend against a wide range of illiquid collateral but only at haircuts which reflect the credit risk that the central bank was taking if it accepted those assets as collateral. The central-bank-as-pawnbroker could then say to banks, “Look, the effective insurance premium that you’re going to have to pay is that you’ll have to pre-position enough collateral in normal times so that you have a guaranteed cash credit line with the central banks sufficient to pay off all your depositors or other people who might run, such as short-term wholesale funding that might disappear.”
If you could do that, then you not only have designed a scheme for supporting banks in a crisis, you’ve actually significantly reduced the likelihood of a crisis erupting in the first place because there should be no bank runs in this world. In 2008, there was an underlying problem of the solvency of the banking system and that created the risk that at some moment people would say, “Well, enough is enough. I’m not prepared to take any more risk. I will run from this bank or whatever financial institution.” A lot of the resultant runs were wholesale runs. People did take their money out and then the Fed had to step in to act as a lender of last resort.
But if we’d had my system in place, there wouldn’t have been the incentive to run. Everyone would know that any bank would always have a sufficiently large cash credit line with the central bank and that, no questions asked, it would be able to get cash to repay anyone who decided they wanted their money back. Even if a few people decided to take their money out, no one else would have an incentive to join them, whereas the problem with a conventional bank run at present is that when some people take their money out, the only sensible thing to do is to take yours out as well before the bank actually runs out of money.
OR: How do you deal with the fact that in a crisis you could have cascading collapses in asset values?
King: The whole point about this scheme is that it recognizes that if a crisis is big enough, the government or the taxpayer through the central bank is always going to be providing insurance of last resort. But what we want to do is to put things on a basis such that banks can’t exploit that foreknowledge by altering their balance sheet in advance to take lots of risk to which the taxpayer is then committed. It seems to me that if there is a big crisis, the taxpayer has no choice but to come to the rescue. What you want to make sure is that the structure of the balance sheets of the financial sector has been limited before the crisis to one that is manageable.
The haircuts, which are imposed on the collateral deposited with the central bank in normal times, are absolutely fixed, and the central bank is committed to providing the cash implied by that haircut against that collateral at any point over some period — whether it be five or eight years, whatever is decided to be the appropriate period. So that when the crisis hits, if asset prices do start to fall, that doesn’t affect the commitment of the central bank to provide the cash that the bank will need. Everyone will know that the bank doesn’t actually have to rush out to make fire sales in order to acquire cash to meet depositors’ needs.
That’s the whole point of the scheme. By making banks pre-position collateral in normal times, it effectively constrains the amount of maturity transformation that they can engage in. That’s like a tax or an insurance premium they pay in normal times so that in bad times when a crisis hits they are entitled, no questions asked, to draw on the predefined and pre-committed credit line with the central bank. Again, no bank would ever have to rush out and engage in fire sales, and that itself will make a big difference to the likelihood of cascading sales of assets and hence falling asset prices.
OR: What do you make of the critiques from some prominent economists about your acknowledgment of the fundamental uncertainty that underlies economics?
King: There was a big debate in the 20th century between one group of economists and statisticians who believed that you could always define probabilities over events and another group that said, “No, stuff happens and you can’t imagine in advance what it will be, and you certainly can’t attach probabilities to it.” The importance of this is that if the first view of the world is correct, then it’s possible to create financial markets in every conceivable kind of risk that could occur, and you can price those risks and you can rely on the market economy to try to ensure that the people best able to bear the risks are doing so.
I think that’s completely false. It’s true there are many risks, like conventional life insurance, where that is true, but there are also risks where that is clearly not true. Stuff happens and that can really affect the outcome of people’s decisions to produce, invest, spend, and so on. You cannot insure against those events in advance, and the market economy cannot provide opportunities to hedge those risks.
This is one reason why — the major reason, probably — in the end you get the sorts of booms and slumps in an economy which conventional economics simply cannot explain. Now, the reason why I think some economists don’t like this idea is that it precludes, almost by its very nature, the view that everything that goes on in the economy can be explained in terms of a mathematical equation. There are certainly many aspects of economic behavior that can be understood more clearly by the use of mathematical models, but the idea that everything can be mathematically modeled — it’s just false. It doesn’t correspond either to the world we live in or to the way people respond to that world.
I think economists who believe that everything can be always expressed in a mathematical form so that you can assume that what drives people in their decisions is always some ruthless optimizing calculus — which some people may not be very good at but basically the smart people are — are deeply delusional. It doesn’t capture the real problems that people face when confronted with a world in which they see this degree of radical uncertainty. The big question then becomes: What does it mean to be rational in that world?
That’s why I also criticize behavioral economics. Behavioral economics says that the optimizing approach to economic behavior is too cold and people are actually human beings and they make mistakes and they are irrational. They identify a long list of departures from optimizing behavior. But I don’t think that’s a very helpful way of thinking about things either, because people aren’t irrational. They’re trying very hard to be rational. It’s just that what it is to be rational in a world of tremendous uncertainty is not well described by the economists’ optimizing model.
OR: In your book, you seem to conclude that the euro as now constituted is not sustainable. Do you see the currency breaking up in the short or medium term?
King: The economic logic, I think, is fairly clear. It’s going to be quite difficult to keep the euro together without accepting that there will be permanent transfers from countries like Germany and the Netherlands to countries in the south. At present, everyone is pretending that that is not the nature of the monetary union, and no electorate in northern Europe has signed up for this. You’ve got a battle between different visions of what the monetary union is about, and this has not been resolved. I think the politicians and the officials in the euro will just try and keep the show on the road and do whatever they can to avoid this ultimate choice becoming apparent. But in the end no monetary union has survived without it ultimately gravitating towards being a political union. That is something which at present the politicians of Europe are consciously saying that they’re not going to do. Germany is adamant that it will not agree to a transfer union.
OR: Do you think that they’ve missed the opportunity to have a two-tiered euro?
King: I think they probably have. I think there was an opportunity to do it and it might have worked. But I think it’s very difficult now because they’re so far down the road of pretending that everyone can stay in. They came very close to asking Greece to leave and then at the last minute balked at that and backed off it. I think it’s going to be quite difficult to return to it, except in the context of another serious crisis. The trouble being that once you get into a crisis, the pressure is to resolve the crisis by throwing money at it, not by saying, “The crisis is telling us something important about the fundamental structure of the monetary union.”
OR: You talk as well about the need to rethink the IMF — what do you see as its role and what reforms would you like to see made?
King: I see the role of the IMF primarily as not being to worry about the details of policies in each country but to get countries to focus on the interactions between economies. The U.K. and Canada worked quite closely to put forward the proposal that IMF reporting on economies should focus more on what we call “spillover reports,” and the IMF has gone some way down that road. But I think it hasn’t really got to grips with the intellectual challenge that is posed by the world economy today. It still seems to think, as many central banks do, that just a bit more patience, a bit more time, a bit more stimulus, and we’ll be fine and back on the road to recovery. I don’t think that’s the case. Basically, I think most economies in the world today could say with some justification that they would be fine — if only the rest of the world was growing normally. But since it isn’t, they aren’t. Then the question is: what do they do?
Well, they’re then tempted to push down exchange rates, to do things which are not in the interest of the world as a whole but might be in their individual interest. In other words, there is a prisoner’s dilemma, as I describe in the book — a collective action problem. And that’s where the IMF comes in. The IMF is a vehicle which can try to encourage people to understand that they could all be better off if they adopted policies which they might think of as not being the best thing to do if only they were making the decision and they had to take the rest of the world as given.
In current circumstances, it seems to me that most economies need to rebalance the structure of demand, spending, and output. But it’s very difficult for any one economy to achieve that on its own. It needs other economies to rebalance as well. I would like to see the IMF taking the lead at creating a strong consensus — not on a list of individual measures that countries should take, but rather on almost a commitment to each other that each would promise to rebalance its economy over a five-year horizon. The willingness to take the measures which each knows it needs to put in place to rebalance its economy would be much enhanced if they genuinely believed that other countries were going to rebalance their economies over the same period. I think that’s the role of the IMF. It’s to do it privately behind the scenes, and to say to people, “Look, you could be better off if you could go along with the promise of these other economies to rebalance,” and get some collective commitment, some trust among economies, actually then to agree to do this. Each country could take its own particular measures.
I fear that the IMF has been too susceptible to wanting to be in the limelight, and I think nothing that the IMF does is a success if the IMF is the news story. It needs to work behind the scenes. Secondly, in the context of Europe, it has got so involved in the politics of Europe. Politically, the IMF is seen to be committed to the idea of making a success of the euro. That’s an economic judgment, which they shouldn’t be making. That’s about politics. As a result, what they’ve done is to get sucked into Europe, and they’ve supported and put money into programs on a scale which the IMF refused to do, often at the behest of the Europeans, in Latin America or Asia.
Not only have they got embroiled in the politics of Europe, which is a mistake, but they’ve rather alienated countries in Latin America or Asia who feel that the European countries — who always provide the managing director — have actually favored Europe. That isn’t very healthy for the credibility, the weight that people in countries outside Europe will give to the views of the IMF.
OR: What is your current view on the effectiveness of quantitative easing and negative interest rates? What is their long-term impact on central bank credibility?
King: I think that the implicit model or intellectual framework that central banks are using is seriously flawed. It seems to be based on the proposition that the only thing holding recovery back is a series of temporary headwinds, and the role of monetary policy is therefore to stimulate spending by offsetting the temporary headwinds until, as time passes, each headwind goes away of its own accord. The trouble with that view is that if the fall in demand is permanent — and I think it is, in response to a realization during and after the crisis that the level of domestic spending was too high relative to long-run income — this monetary policy cannot succeed. You’ve got to find another way to fill the gap. One way would be through export demand, external demand, not domestic demand. Another would be to embark on a long and serious program of reforms to the performance of the economy, the supply side, that would create beliefs that future incomes would be higher than people currently think. That would support spending and help to validate some of the debt that we’ve inherited from the past.
That’s the kind of thing that you would need to do. But if you mistakenly believe that all we have to face are temporary headwinds, what you find is that when you cut interest rates it does work for a short period but then the recovery peters out. Then you have to cut them again. If you have the view that we only face temporary headwinds, and the true story is that actually it’s a permanent fall in demand, what central banks find is that they are inexorably on a path of ever-lower interest rates. You need falling interest rates to maintain some sort of recovery — not low rates. I think this is where central banks are today, and that’s why they end up doing things they never imagined they would do, such as pushing interest rates into negative territory, buying assets which they would never normally contemplate buying in order to create money, and generally, almost in desperation, doing things on the grounds that “Surely if we do this once more, we’ll be all right.” But they won’t.
If there’s a permanent fall in demand and you don’t take the measures necessary to fill the gap created by that but keep relying on a sequence of monetary policy easing, then you’ll end up still needing yet more monetary policy easing. If you try to raise interest rates during this period, you’ll end up having to reverse that, as most central banks that have tried to raise rates have ended up doing. We’re not in a happy place.
OR: Do you see the need to reset the currency system? Do you see there being a role for gold or some other sound-money anchor?
King: No, I think that we have been gradually groping our way towards creating a discretionary system that made sense, and I think we got a long way towards that in creating independent central banks and a general inflation targeting framework. I think in the crisis we learned we had to do more to decide under what conditions money would be created in order to keep the banking system afloat when there was a loss of confidence in it. I think if we implement the “pawnbroker for all seasons” idea, we have a basic framework for maintaining monetary stability. We don’t need to rely on things like gold. The big problem with gold is that what we learnt through the crisis and at other times is that there will be moments when we will need to accept flexibility in exchange rates and in terms of the supply of money.
After Bretton Woods we had a period with floating exchange rates among all the big economies of the world. It worked pretty well. What didn’t work well was that some economies that were becoming very big decided to have fixed exchange rates, and then some of the big economies, as in the monetary union in Europe, created fixed exchange rates among themselves. All of this, I think, has been an unfortunate development.
As long as we recognize the need for floating exchange rates, then I think we don’t need to have something like gold, which constrains our ability to increase the supply of money when you need to do it. It’s very striking that in the 19th century whenever there was a financial crisis, the gold standard was in effect suspended. Therefore, you need a domestic standard which has as much credibility in normal times as the gold standard and you need a mechanism for dealing with crises. Both of these, I think, are about how much money should the central bank create
The problem at present is that we started off in a position that was not sustainable when the crisis hit and there needed to be quite big changes to the structure of our economies with implications for the level of domestic demand. In the U.S. and the U.K. and some European economies, domestic demand needed to fall, and in other economies, like Germany and China, it needed to rise. We’ve not taken the policy steps in order to achieve that. Monetary policy can’t do it. Until we recognize that fact, I think we’re going to be stuck pursuing monetary policy which will be less and less effective and ultimately damage the credibility of central banks.
There is already real doubt about the credibility of central banks. You see that in the case of the Bank of Japan.
OR: What is your view on the consequences of Brexit?
King: I’m in the United States for the fall. I was very surprised to see that policymakers in the U.S. and elsewhere in the world thought that the possibility of Brexit before the referendum was one of the biggest risks facing the world and it affected their policy decisions. Now that the event has occurred, no one here seems to see the problem in quite such cataclysmic terms. The world didn’t come to an end, and I think the long-run consequences are likely to be much smaller than many people claim.
I think that what’s needed now, and it is very important for the U.K., is a very clear intellectual framework set out by the British government to delineate what its immigration policy is going to be and what that means as the basis for trade negotiations. But I see no reason why the U.K. could not say to countries with which the E.U. already has a trade deal, “Why don’t we just roll the terms of that over to a bilateral deal?” To countries with which the E.U. does not have a trade deal, like China, the U.K. can either create a new trade deal, in which case we’re better off — or at least we can’t be worse off than we are now.
I think on the trade side, again, there are opportunities here. The tricky thing will undoubtedly be negotiations with the rest of the European Union. But again, as long as the U.K. has a very clear and well-explained and articulated strategy based initially on a policy for immigration, then other people need to be told that that is not negotiable and we’ll discuss trade given that. I think we’re certainly capable of doing it. I don’t myself think that when we joined the European Union 40-odd years ago that transformed the British economy, and I don’t think leaving it is going to transform the British economy either — in either direction. My guess is that 30, 40, 50 years from now we’ll look back and basically say, “This wasn’t the most important thing that happened to the U.K. in that time.”
Lord Mervyn King served as governor of the Bank of England and chairman of its Monetary Policy Committee from 2003 to 2013. His book The End of Alchemy was published this year.